Back to the future: the nature of regulatory capital requirements

Financial Markets, Institutions & Instruments, 2008

In this paper the authors study the role of regulatory banking capital and analyze the incentive effects of the Basel II Accord. They argue that Basel II may become a source of systemic risk due to endogenous risk and the risk sensitivity of the capital requirements. In this context they note that financial instability may enter via the asset side of the banks' balance sheets when banks are forced to sell assets in order to maintain the capital buffer prescribed by Basel II.

2012

We examine the pervasive view that "equity is expensive," which leads to claims that high capital requirements are costly and would affect credit markets adversely. We find that arguments made to support this view are either fallacious, irrelevant, or very weak. For example, the return on equity contains a risk premium that must go down if banks have more equity. It is thus incorrect to assume that the required return on equity remains fixed as capital requirements increase. It is also incorrect to translate higher taxes paid by banks to a social cost. Policies that subsidize debt and indirectly penalize equity through taxes and implicit guarantees are distortive. Any desirable public subsidies to banks' activities should be given directly and not in ways that encourage leverage. And while debt's informational insensitivity may provide valuable liquidity, increased capital (and reduced leverage) can enhance this benefit. Finally, suggestions that high leverage serv...

Review of Finance, 2016

This article discusses the optimal leverage ratio and capital requirements when asymmetric information exists between the bank and the regulator. We show that the optimal requirements take different forms in the short and long run. In either case, imposing the risk-weighted capital requirement without considering the incentives of the bank to misreport its risk profile is never optimal by itself. In the long run, the optimal requirements take the form of a leverage ratio requirement on top of the risk-weighted capital requirement. The add-on leverage ratio requirement, which serves as a compensation for the limited supervisory power of the regulators, should be set such that the risk-taking behavior of the bank is unchanged from the situation in which the regulator uses the risk-weighted capital requirement alone, and the misreporting incentive of the bank is eliminated by the add-on leverage ratio requirement.

SSRN Electronic Journal, 2000

We consider a model in which banking is characterized by asset substitution moral hazard and managerial underprovision of effort in loan monitoring. The privately optimal bank leverage efficiently balances the benefit of debt in providing the discipline to ensure that the bank monitors its loans against the benefit of equity in attenuating asset-substitution moral hazard. However, when correlated bank failures impose significant social costs, regulators bail out bank creditors. Anticipation of this action generates multiple equilibria, including an equilibrium featuring systemic risk, in which all banks choose inefficiently high leverage to fund correlated, excessively risky assets. Leverage can be reduced via a minimum equity capital requirement, which can rule out asset substitution, but this also compromises debt discipline. Optimal capital regulation requires a two-tiered capital requirement, with a part of bank capital invested in safe assets, unavailable to creditors upon failure so as to retain market discipline, and made available to shareholders only contingent on solvency in order to contain risk-taking. We also consider a dynamic state-contingent bailout policy in which, rather than always bailing out all banks, the regulator optimally bails out banks only when a sufficiently large number of banks have failed. Used in conjunction with the two-tiered capital requirement proposed, this can contribute to both ex ante and ex post banking stability.

Journal of Financial Intermediation, 1996

We show that in an imperfect information environment the equity value of an impaired bank may increase or decrease when it is required to meet a capital standard. Regardless of the change in the bank's equity value, however, its stock price will fall in response to a forced recapitalization, consistent with recent empirical evidence. Simulations of our model suggest that this stock price decline is likely to be larger the smaller is the share of ownership held by the managers of the bank, also consistent with recent empirical evidence in the literature. Our model further predicts a rise in bank's non-interest expenses following a required recapitalization. Given the increase in the regulator's exposure that would accompany a reduction in the bank's market value of equity, the regulator may choose not to enforce the regulation. Hence, capital regulation may be timeinconsistent in this situation and consequently not have its intended risk-mitigating incentives.

2013

Basel regulators have received widespread criticism for failing to prevent two credit crises that hit the U.S. over the last two decades. Nonetheless, banks were considerably overcapitalized prior to the onset of the 2007-2009 subprime crisis compared to those which had undergone the 1990-1991 recession. Therefore, if capital requirements were achieved prior to the subprime crisis, how could the Basel framework be blamed again for having accelerated if not caused another credit crunch? In this paper, we find that the answer to this puzzle lies in the changing dynamics between two different regulatory requirements, the capital ratio and the leverage ratio. Indeed, we show that the change in risk-weight on residential mortgages which was introduced in the Basel II framework was sufficient to reverse the correlation pattern between both ratios; in turn, this resulted in a change to the binding constraint on banks. We also demonstrate that these dynamics are governed by a formula linkin...

SSRN Electronic Journal, 2000

We address the following questions concerning bank capital: why are banks so highly levered, what are the consequences of this leverage for the economy as a whole, and how can robust capital regulation be designed to restrict bank leverage to levels that do not generate excessive systemic risk? Bank leverage choices are a delicate balancing act: credit discipline argues for more leverage so that creditors have adequate skin in the game, while balance-sheet opacity and ease of asset substitution by bank managers and shareholders argue for less. Disturbing this balance are regulatory safety nets that promote ex post financial stability but also create perverse incentives for banks to engage in correlated asset choices ex ante and thus hold little equity capital. We discuss how a two-tier capital requirement can cope with these distortions: a core capital requirement like existing capital requirements, and a special capital account that must be invested in Treasuries, accrues to the bank's shareholders as long as the bank is solvent, and accrues to the regulators (rather than the creditors) if the bank fails. The special capital account requirement ensures creditors have skin in the game and also provides the second margin of safety in the calculation of capital adequacy--a buffer for the regulator's own "model risk" in calculations of needed capital buffers.

Journal of Banking Regulation

The emergence of risk-based capital regulation that is allowing banks to use their internal risk models for regulatory purposes was among the main regulatory developments prior to the financial crisis. During the crisis, it became evident these models underestimated the level of risk. The post-crisis regulatory approach brought a reversal of policy by significantly reducing the scope of risk-based capital regulation and making regulations less risk-sensitive. At first glance, this appears to be a step back toward an antiquated, less sophisticated regulatory regime. This article analyses these two regulatory policy transformations: from less risk-sensitive to risk-based before the crisis and from risk-based to less risk-sensitive subsequently. Its main conclusion is that a mixed regulatory system is superior to either purely non-risk-sensitive or purely risk-based regulation, because a mixed system can help mitigate the negative incentives of both non-risk-sensitive and risk-based re...

Economic Review

RSF: The Russell Sage Foundation Journal of the Social Sciences, 2017

This article assesses the benefits and costs of key provisions of the Dodd-Frank Act that strengthened regulation following the financial crisis. The provisions are placed into five groupings: clear wins, clear losses, costly tradeoffs, unfinished business, and too soon to tell. Clear wins include higher prudential standards, including for capital; the single-point-of-entry resolution authority; creation of the Consumer Financial Protection Bureau; and greater transparency and oversight of derivatives. Clear losses are restrictions on Federal Reserve emergency lending authority and forcing the Federal Deposit Insurance Corporation to obtain permission from Congress before providing temporary liquidity guarantees. Costly tradeoffs are the Volcker Rule and the Lincoln Amendment. Unfinished business includes regulatory consolidation and more independence for the Financial Stability Oversight Council and the Office of Financial Research. Too soon to tell are requirements and standards for leverage ratios, capital buffers, stress testing, and liquidity requirements.